Question

Byrd Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 185,000 shares of stock outstanding. Under Plan II, there would be 135,000 shares of stock outstanding and $1.9 million in debt outstanding. The interest rate on the debt is 7 percent and there are no taxes. a. If EBIT is $425,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) b. If EBIT is $675,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) c. What is the break-even EBIT? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)

Please show all work and formulas

Answer 1

(a) Plan 1: No Debt All Equity, EBIT = Net Income (as Income Tax and Interest Expenses are zero) = $ 425000. No of Shares = 185000

EPS = 425000 / 185000 = $ 2.29

Plan 2: Debt = $ 1.9 million and Interest Rate = 7 %

Interest Expense = 0.07 x 1900000 = $ 133000

EBIT = $ 425000

Less: Interest Expense = $ 133000

PBT = $ 292000

Less: Tax = $ 0

Net Income = $ 292000 and No of Shares = 135000

EPS = 292000 / 135000 = $ 2.1629 ~ $ 2.16

(b)

Plan 1: No Debt All Equity, EBIT = Net Income (as Income Tax and Interest Expenses are zero) = $ 675000. No of Shares = 185000

EPS = 675000 / 185000 = $ 3.649 ~ $ 3.65

Plan 2: Debt = $ 1.9 million and Interest Rate = 7 %

Interest Expense = 0.07 x 1900000 = $ 133000

EBIT = $ 675000

Less: Interest Expense = $ 133000

PBT = $ 542000

Less: Tax = $ 0

Net Income = $ 542000 and No of Shares = 135000

EPS = 542000 / 135000 = $ 4.0148 ~ $ 4.015

(c) A break-even EBIT is that value of EBIT at which the EPS under both plans are equal.

Let the break-even EBIT be $ k

Therefore, EPS under Plan 1: EPS1 = k / 185000

EPS under Plan 2: EPS2 = (k - 133000) / 135000

Now, EPS1 = EPS2 if EBIT is break-even

k / 185000 = (k - 133000) / 135000

0.7297297 k = k - 133000

k = 133000 / 0.27027027 = $ 492100